Illiquid Real Estate Investments May Protect Investors from Bad Instincts

If you’re in danger of shooting yourself in the foot, it’s a good idea to remove the bullets.

The same principle can be applied to investing. It takes the form of moving a modest portion of your portfolio into an illiquid (but carefully selected) investment, if you’re prone to be overly attentive to the day-to-day fluctuations in the market value of your stock and bond portfolio.

Investors generally know they’re supposed to keep their time horizon in mind as they behold the inevitable bumps in the market. However, for many, emotions overpower reason and they flee to cash at the first sign of a market correction. (This is not intended as a prediction of an impending market drop, but we all know it’s bound to happen sooner or later.) The inevitable result is suboptimal returns, because panicky investors typically wait too long to get back in the market. Plus they often pull out when the market is at the threshold of a turn-around.

So, what’s a good way to limit the risk of falling into that trip? One approach that can work for some people is investing in a real estate private placement limited partnership. LPs are very different from REITs those publicly traded real estate investment trust units whose market value is established by the market in the same manner as stocks. LPs are not valued daily. In fact you might not see a valuation for more than a year. And selling out of LPs prematurely (for example, in less than five years) is difficult and/or expensive.

Ample research

Does this mean you’re flying blind until the LP is liquidated and your capital is returned? Not at all. Consider the example of an LP that invests in apartment complexes. Before investing, you will have ample time to read through a detailed prospectus that will lay out the details of what property or properties the partnership will buy, and all of the relevant factors that are believed to make them a desirable investment.

The general partner of the LP, who also has skin in the game, has the same incentive as you to conduct a thorough “due diligence” effort.

In the case of residential real estate, that includes such data points as current and historic rent revenue, occupancy rates, the physical condition of the apartments, demographics and the economic base of the local community. (Note: Some LPs only invest in mortgages instead of the actual property. Those LPs fulfill a different function in a portfolio.)

Also, the general partner may lay out a strategy to enable the apartments to generate higher rent, such as through a plan to update apartment kitchens and bathrooms as the tenants turn over.

What you will know—and what really matters, if income generation is the main purpose of the investment in your portfolio—is whether you’re getting the distributions you expect. And if the amount of those distributions goes up, it’s a safe bet that the value of the real estate that’s generating them has also gone up in value, other things being equal.

Unique characteristics

In addition to being illiquid, LPs have some other important differences from mutual funds, ETFs and individual securities.

For starters, most are deemed suitable only for “accredited investors.” To hold that status you need either at least a $1 million net worth (excluding the value of your home), or have earned at least $200K over the last two years ($300K for couples) and an expectation that your income will remain at that level in the current year. This requirement reflects financial regulators’ recognition that private LPs are illiquid, and thus not a suitable investment for people of lesser means who might need greater liquidity. Minimum investments in these LPs tends to be in the $100,000 to $250,000 range.

Another important distinction is that they entail some tax benefits, such as the sheltering of some income due to underlying depreciation expense and borrowing costs incurred by the partnership. For that reason, private LPs are generally not suitable for being held in a qualified retirement plan. Also, LPs held in a retirement plan could incur a tax liability for something called “unrelated business taxable income,” or UBTI.

There are more reasons to make this kind of investment than simply protecting yourself from a tendency to panic and sell liquid assets. Real estate, when purchased at the right price and managed well, can produce excellent returns. But as with any other investment, you need to choose wisely, and there are no guarantees.